Live From Bio: Investing in Orphan Drugs

There's money to be made in selling drugs to just a few people.

Fool contributor and health-care sector editor Brian Orelli is hanging out at the Bio International Convention this week. Stay tuned for news about the hot topics at the conference that will affect the industry and the stocks you invest in.

Developing drugs that treat very few people may seem like a losing endeavor, but the more than 300 drugs that have been developed since the Orphan Drug Act was put in place 25 years ago says otherwise. Sure, we're not talking about revenues like the almost $13 billion that Pfizer's (NYSE:PFE) Lipitor brought in last year -- unless you add all the drugs together. But the act did create enough incentives to make it worth biotech's trouble to develop drugs for diseases that not many people have.

What's in it for investorsOne of the speakers at the conference was Timothy Cote, from the FDA's Office of Orphan Products Development. His office isn't in charge of approving drugs. Rather, he encourages biotech companies to apply for the orphan drug designation -- and weeds out those that are trying to get a free ride. He came up with a list of six reasons why companies should develop orphan drugs; surprisingly, most of them are good for investors as well:

1. It's the right thing to do. While he's right, I don't think this is a good reason for investors to invest in companies developing orphan drugs. In my opinion, it's better to help people by donating your stock after it goes up in value.

2. Blockbusters happen. Believe it or not, Allergan's Botox, Amgen's (NASDAQ:AMGN) Epogen, and Novartis' (NYSE:NVS) Gleevec all had orphan drug designation. While these might be the exceptions to the rule, they should give investors hope of striking it big.

3. Incentives. This is really the ticket to making orphan drugs profitable. The government gives companies a 50% tax credit on clinical trial costs, a break from paying PDUFA fees -- which, given the recent fee increases, is some serious cash savings -- and the all-important seven years of exclusive sales.

5. Viable business model. Companies like Rule Breakers pick BioMarin Pharmaceutical(NASDAQ:BMRN) have proven that orphan drug development can be financially viable.

6. Treating rare diseases is medicine for health care's "trust deficit." The evening news loves to trounce drug companies -- just look at the reactions when new efficacy and safety issues come to light for drugs like Merck's (NYSE:MRK) and Schering-Plough's (NYSE:SGP) Vytorin, and GlaxoSmithKline's (NYSE:GSK) Avandia. Developing drugs for rare disorders could improve drug developers' public image, although I'm not sure how much that would help drug sales.

What to look for when investigating companies that are working to develop orphan drugs is how fast they bring a drug to market. Small clinical trials -- often with fewer than 100 patients -- allow companies to keep costs down and start collecting revenue from their drugs quickly.

Another thing the panel made pretty clear was that it's easier to get FDA approval for a drug if the disease is clearly defined. Investors should therefore look for drug companies that can design trials with clear clinical endpoints. For example, BioMarin's Kuvan was approved based on a blood test, which is obviously less complex than a timed walking test that could take into account multiple parameters.

Investing in companies that are developing orphan drugs isn't for everyone. There's a certain amount of risk -- as there is with any drug-developer -- and the payoffs, excluding the few exceptional cases, are often less than stellar. But investing is always a risk versus reward endeavor -- and, if a company can lower its risks by moving quickly and taking advantage of government subsidies, an otherwise unloved stock can create a serious buying opportunity.